Exchange traded funds provide investors with the opportunity to gain exposure to an index, a commodity, a bond or a basket of assets like an index fund. And there are several order types an investor can choose when investing in ETFs with important distinctions that can impact the price. Here we explain the difference between order types and why an investor may choose one versus another.
An Order Type to Guarantee an Execution
A market order is an order to buy or sell an ETF at the next best available price. That means that a market order is generally guaranteed an execution if there is contra-side liquidity, but not a price.
It is fundamentally different to a limit order, which sets the maximum price you are willing to pay, or the minimum price for which you are willing to sell. A limit order is guaranteed a price, but not an execution if no contra-side orders are at that price.
If you use a market order, you are taking a risk that the prices available when your order is received by the venue are just as good as the ones you saw when you sent the order in the first place – i.e., if you sent a market buy order, the price of the ETF stayed the same or went down while your order was in transit. The next available prices may be worse for you than before, but you’ll still get your guaranteed execution. And note: market orders are distinct from a market-on-close order, which aims to participate and then execute at the official exchange auction closing price.
While ETFs are supposed to be priced at their fair value it may be assumed that a market order or a limit order is going to get the same price anyway. But it’s possible that an investor might see a price when they log into their brokerage account, but that price might not be there anymore when that order gets to the trading venue because the ETF market maker may not have refreshed their liquidity yet. There can be a risk that the investor may buy an ETF for more than its fair value.
An ETF market maker should, in theory, be willing to buy and sell an unlimited amount of ETF shares at their fair value price, since shares can always be created or redeemed with the issuer at the end of the day to clean up the market maker’s holdings. But that doesn’t mean an ETF market maker will put an unlimited amount of ETF shares on the bid or offer price all day, every day, or at the very moment an investor’s market order hits the order book at the exchange. The costs of trying to implement such a strategy far outweigh the benefits for an ETF market maker.
ETF market makers have to take into account how many ETF shares they are quoting across the entire industry of more than 2,000 ETFs. Throughout the trading day they are sending their bids and offers across most of the U.S. equity exchanges, as well as off-exchange venues in order to cast the widest net possible to capture customer order flow. Yet there’s only so much liquidity to go around at every given moment in the trading day. So while an ETF market maker may be willing to price an entire order at fair value, and buy or sell the shares of the ETF an investor is willing to trade, time is still needed to find and interact with that liquidity. A market order won’t necessarily do that because it will generally trade upon entry into the market.
An Order Type With a Safety Feature
A limit order will eventually get to a fair value price, but it will take its time waiting for a contra-side order to get there. Using a limit price sets the maximum price at which you are willing to buy an ETF, or the minimum price you are willing to sell an ETF to the market maker. An investor can set that price above (or below) the current best Offer (or Bid), to allow the flexibility of a short term price change, yet retaining the protection from a major price move.
ABC ETF is currently showing a quote of Bid $50 and Offer $50.05. Rather than a market order to buy, you can set your limit at $50.05, $50.10 or even $51.00 (note: if you choose a limit price at or above the current price, we refer to that as a marketable limit). Your limit order to buy will still execute at the best possible price available, however what it won’t do is execute past your limit price. You are protected from a short term lack of liquidity in the marketplace, and from buying the ETF well above the fair value price at the time of the trade. If there is a price where you would be unhappy with your execution, and would have preferred not to have traded, then you have a limit price. Your order can reflect that fact and be your safety glasses.
Why it’s important to choose the best order type
In selecting the right order type, the investor needs to consider what risks they are willing to accept in their execution strategy. This involves deciding what’s more important: speed of execution or some price protection for the trade. Using limit and marketable limit orders can allow the time it sometimes takes for an ETF market maker to refresh their supply of liquidity in order to execute the trade appropriately.
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